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A break-up of Euro euphoria

Without a eurozone-wide taxing and spending authority to assume responsibility for guaranteeing government debt, the region is destined for a long-lasting recession.

Recently, the 17 European nations using the euro agreed to stricter controls on government deficits. As excessive borrowing caused the credit crisis in Italy and other Mediterranean states, this agreement sought to convince investors those governments would put their fiscal houses in order and pay their debts.

Initially, markets responded well – interest rates on Italian bonds fell. However, after a brief euphoria, those rates rose above 7 per cent. If those stay high, the Italian government will not be able to afford to roll over bonds as those come due and pay its bills. It would default.

Investors are rejecting the euro pact, because the agreement does not effectively meet the funding needs of Italy and other troubled governments, address the weak balance sheets of European commercial banks, or fix underlying structural flaws in the euro architecture.

The €440 billion European Financial Stability Facility provides loans – guaranteed by 17 eurozone member states as a whole – to tide over troubled governments. However, those bailouts impose huge cuts in spending and tax increases. Coupled with austerity plans adopted by France and other healthier European governments, those packages are pushing Europe into a recession that could last several years.

The economic contraction will be most severe in Mediterranean countries, and their GDP could easily plunge so much that tax revenues fall faster than governments can reasonably cut spending. If governments cut spending too much in the face of contracting private sector employment, civil unrest could force governments to exit the euro, and bondholders would lose a great deal in such a panic.

The bailout package for Greece required private bondholders to take a 50 per cent haircut, but the more recent deal to save the euro included assurances that future eurozone bailouts would not require private participation. Those promises do little to comfort bondholders. If the governments can’t raise taxes to pay what they owe, the EFSF will be inadequate in the face of widespread panic, especially if the eurozone splinters.

European commercial banks are at risk, because they hold large amounts of Italian, Greek and other troubled governments bonds, and many of their private loans could fail in the oncoming recession. Those banks obtain considerable financing in the bond market, and much of that must be rolled over in 2012. Investors will be quite apprehensive about buying new bonds from banks with such shaky assets.

The eurozone lacks the resources necessary to resolve the current crisis, because it lacks a central government that taxes, spends and issues bonds to help member states finance social programs, infrastructure and other public purposes, and assist member states in distress.

The eurozone, as a whole, cannot issue the often proposed ‘eurobonds’ to raise the funds to stabilise the finances of Italy and other troubled countries, and fix European banks, because it lacks taxing power to back up such debt. Only fools would invest in long-term bonds backed up by future voluntary contributions of 17 member governments, because insolvency of even one large government could cause those bonds to fail.

In 2008, the US Treasury issued $750 billion in new US bonds to create the TARP and bailout banks. Quite aside from the €440 billion in the EFSF, the eurozone would likely need more than €500 billion, and perhaps €1 trillion, to bailout its banks. It can’t raise that kind of money without the authority to tax and issue bonds.

To get their economies going again and pay their debts, Italy, Greece and other troubled countries must start by exporting more than importing, and accomplishing budget surpluses. This would require Germany and other northern creditor states to endure trade and budget deficits, and a profound shift in the cost competitiveness of the Mediterranean versus northern European economies. That could only be accomplished by currency devaluation or years of deflation to drive down wages in southern economies.

As the Mediterranean states and Germany both use the euro, devaluation is not possible. Wage deflation would require years of severe austerity and recession that is not politically sustainable. Investors know this, even if European leaders like Angela Merkel and Nicolas Sarkozy won’t admit it.

In the end, the austerity and budget disciplines in troubled countries must be accompanied by the creation of a genuine European taxing and spending authority that would assume responsibility for guaranteeing their debt.

Short of this, the euro can’t survive.

Peter Morici is a professor at the Smith School of Business, University of Maryland School, and former Chief Economist at the U.S. International Trade Commission.

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